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Executives

Karen Fisher – VP, IR and Compliance

Kevin Hell – CEO

Dan Halvorson – EVP and CFO

Analysts

John Bright – Avondale Partners

Paul Coster – JP Morgan

Jim Goss – Barrington Research

Justin Cable – Global Hunter Securities

DivX, Inc. (DIVX) Q3 2008 Earnings Call Transcript October 30, 2008 4:30 PM ET

Operator

Good day, everyone, and welcome to the DivX third quarter 2008 operational and financial results conference call. Today's conference is being recorded.

And at this time, I would like to turn the call over to Karen Fisher. Please go ahead, ma'am.

Karen Fisher

Thank you. Good afternoon and thank you for joining the management team of DivX. I am Karen Fisher, Vice President of Investor Relations and Compliance. And with me on the call today is Kevin Hell, our Chief Executive Officer, and Dan Halvorson, our Executive Vice President and Chief Financial Officer.

Before we get started, I would like to read a brief Safe Harbor statement and then turn the call over to Kevin Hell.

Statements made during this call that are not strictly historical in nature constitute forward-looking statements. Such statements include, but are not limited to, the Company's position in the digital media space, its confidence in its growth prospects and its plans to increase stockholder value, the Company's focus on 2008, the Company's plans for expanding its core licensing business, expectations for DivX Connected, plans for extending the Company's content licensing partnerships, and the Company's anticipated financial results for its full year 2008. Such forward-looking statements involve known and unknown risks, uncertainties, and other factors which may cause actual results to be materially different from those expressed or implied by such forward-looking statements.

These statements include, but are not limited to, the risk that customer use of DivX technology may not grow as anticipated, the risk that anticipated market opportunities may not materialize at expected levels or at all, the risk that the Company's activities may not result in the growth of profitable revenue, the risk that the Company's financial performance for the full-year 2008 may not meet expectations, and other factors discussed in the risk factor section of the Company's most recent reports filed with the Securities and Exchange Commission.

All forward-looking statements are qualified in their entirety by this cautionary statement. DivX is providing this information as of the date of this call and does not undertake any obligation to update any forward-looking statements discussed in this call as a result of new information, future events or otherwise, other than as required under applicable securities laws.

For those of you not able to stay on the call today, an audio webcast will be archived on our Web site under Events and Presentations at www.investors.divx.com.

At this time, I would like to turn the call over to Kevin Hell.

Kevin Hell

Thank you, Karen. Hello and thank you for joining us on the call today. I'm pleased to report that we delivered another consecutive quarter of strong business results, and we remain well on our way to realizing our vision of enabling consumers to enjoy high quality digital video on any device and in any location.

As announced earlier today, our financial results were strong and reflect continued execution in our business. We delivered solid top line results and continued to drive profitability through prudent expense management, with $24.4 million in revenue and non-GAAP EPS of $0.16.

What's more, as Dan will discuss later on the call, we are raising our profitability guidance. These results illustrate the continued robustness of our highly profitable business model despite weakening global economy.

I'd like to take a minute to discuss the macroeconomic climate in more detail, which is obviously a topic that is front and center in everyone's mind. Views regarding the global economy are widespread, and consumer spending in particular is a question mark. What's more, from our relationships with retailers and OEMs, we've heard early evidence of a drop-off in retail and online sales and a shift toward less expensive, lower end consumer electronics.

Although it is difficult to predict exactly how this will play out, we continue to focus on maintaining our historically high gross margins, managing expenses tightly, and delivering strong cash flow from operations. We believe our continued focus on these key principles, coupled with our strong balance sheet with $130 million in cash, makes us well positioned to ride out the storm and will allow us to capitalize on the growing adoption of digital media among global consumers.

We've talked on past calls about the importance of devices, content, and software to our overall success, and in the third quarter we achieved significant wins in each of these categories. In the consumer electronics business, we continued to expand the DivX device ecosystem well beyond the red laser DVD player market. We now tier one OEM products who are bringing in a variety of categories, including Blu-Ray devices, digital televisions, set top boxes, mobile phones, and high definition devices.

We've talked a lot about the importance of emerging product categories in previous calls, and in Q3, we have begun to see increasing diversification through devices beyond red laser DVD players. We expect that to continue as the market for a variety of DivX-enabled consumer products accelerate.

Turning to our Powered by DivX content strategy, we announced the agreement with our first premium content retailer, CinemaNow, and earlier this month, signed a milestone agreement with Warner Bros., the second major studio to endorse DivX technology.

In the software segment of our business, we continued to build momentum toward the upcoming release of the next generation of DivX technology, DivX 7.0, which will introduce our cutting edge H.264 solution to the market.

We also continued to grow the DivX community around a variety of software products, including our industry leading high definition web player, our mobile player, and a variety of innovative plug-ins for Internet services that are driving our DivX connected program.

Let me walk through these developments in more detail. Let me begin with our licensing business. Our robust penetration of new shipments in red laser DVD player market was 44% for the 12 months ending June 30, 2008, a growth roughly 20% over the previous 12-month period.

Meanwhile, we are increasingly focused on executing agreements and certifying devices in emerging product categories, including Blu-Ray players, set top boxes, digital televisions, mobile devices, and gaming consoles. Consistent with my earlier remarks, we believe that success in these new product categories will signal the health of our long-term licensing business. We've planted the seed for broad penetration in emerging product categories, and as these product categories mature, our licensing business should benefit and accelerate.

This transition will take time, of course, but it has definitely begun, and we are well positioned to be a checkless feature on new device categories that will replace red laser DVD players. In particular, we've seen strong growth in the Blu-Ray category, where DivX is clearly well-positioned to become a checkless feature.

In Q3, we announced new DivX certified Blu-Ray models from a number of consumer electronics brands, including Panasonic, JVC, Pani and Pioneer. All told, we have now certified over 60 individual Blu-Ray models, and we expect that number to increase significantly in the coming quarters.

And we believe the appeal of DivX in the Blu-Ray category will only increase with the upcoming release of DivX 7.0 and our corresponding DivX Plus Certification Program. The new release will introduce our H.264 technology to consumers and potentially increase the creation and distribution of HD DivX files, thereby driving increased demand for DivX compatibility on Blu-Ray devices in much the same way that the initial release of our MPEG-4 software drove the creation of our existing DVD player licensing business.

We are, in fact, weeks away from shipping our first software development kit to key partners to be in the process of integrating our H.264 solution on embedded chip sets, and we are excited about the positive effects this program will have on the availability of a wide variety of DivX certified high definition products.

Digital televisions represent another significant emerging product category for DivX and another area where we saw increasing traction with our partners in Q3. We recently announced an exciting agreement with Samsung Electronics, the leading provider of digital televisions worldwide, to add DivX playback to multiple product lines of Samsung digital televisions. This agreement with the market share leader represents significant accomplishment for DivX and one we hope to replicate with additional digital television partners in the coming months and quarters.

This quarter also saw the release of the first DivX certified DTV in the Japanese market from ByDesign, as well as the certification of a high-powered chip from Broadcom that will pave the way for even more DivX certified HD televisions.

Set top boxes are another important strategic category for us. And over the last several quarters, we have certified chip sets and built relationships with key manufacturers to bring DivX certified set-top boxes to market.

We're pleased to report that in Q3 we announced the first agreements with two major manufacturers for set top boxes. LG and Vestel, and are close to completing certification on several additional devices. The devices will support the playback in DivX content through a USB port, and in the future, we hope to add support for network streaming DivX content.

Let me provide a quick update on our mobile certification program before I turn to a discussion of our content strategy. Q3 saw the release of the Samsung INNOVATE, the latest high quality mobile device to achieve DivX certification, and we currently have a number of new devices in our lab for testing. The total number of DivX certified mobile devices now stands at 15, and we are pleased with our traction in this space.

Another compelling indicator of the consumer demand for DivX in the mobile segment comes from the adoption of our software-based DivX mobile player. We have offered a version of this mobile player for devices that are not hardware certified on DivX.com for a number of months, and we've seen adoption increase dramatically.

In fact, since the launch we've seen over 650,000 downloads of the DivX mobile player and are now on track to see over 1 million by the end of 2008. This metric clearly shows the strong demand for DivX playback and mobile devices, and we believe that it is an indicator of the potential success of DivX in this market.

To recount the state of our licensing business, our position in the red laser DVD player market remains strong, and we are seeing continued traction in important merchant product categories that will drive the future growth of our business.

I'll now turn to a discussion of our progress with premium content partners. You will recall that we announced our first major premium content partner, Sony Pictures, earlier this year, and in July, announced an agreement with CinemaNow, our first retail partner.

Earlier this month, we reached another significant milestone for our content business with the completion of an agreement with Warner Bros., the second major content provider to offer format approval for DivX video and digital rights management technology. This development, together with our prior agreement with Sony Pictures, gives us access to almost half of all titles currently available for digital distribution. It provides strong momentum for DivX in the premium content space.

The Warner Bros agreement covers all international regions and provides for high definition distribution next year in addition to standard definition. Moreover, our continued progress with premium Hollywood content helps drive our licensing business immediately and enables us to build a DivX-based, high quality premium content network with retail distribution partners who are powered by DivX strategy.

Another powerful driver of our success in the content space is the overall size and engagement of a broader DivX global community. We've analyzed our historical breadth and removed the periods in which we operated Phase6 to quantify our progress here. Since March 2008, we have averaged over 10.3 million monthly visitors to DivX.com. This is up 61% when compared with 6.4 million monthly visitors averaged in the first half of 2006.

Turning to software downloads during the same periods and excluding other updates, we averaged over 6.7 million monthly downloads of our software bundle since March 2008 compared with 4.7 million downloads in the first half of 2006.

Finally, since March 2008, we averaged 87.1 million Player and Web Player banner impressions per month, which compares with 78.6 million per month in the first half of 2006.

Part of this growth has been driven by the increasing adoption of our Web player by thousands of third-party Web sites. These statistics clearly demonstrate increasing size and scope of the DivX community and underscores the strong value proposition of DivX software to our consumers.

It's also a primary driver behind the increasing revenue we have realized from our toolbar distribution deals. What's more, we expect the upper trend in user engagement to increase with the impending release of DivX 7.0, the next version of our core software suite.

As I've discussed in the past, H.264 has emerged as the new standard for digital video creation and delivery. We've made strong strides in product typing H.264 and have released several beta versions of DivX H.264 software to positive acclaim from the digital video community. The DivX 7.0 software release will officially introduce our H.264 solution to our global community, and we are working in parallel to launch a new certification program called DivX Plus that will add DivX H.264 support to a variety of devices. The DivX 7.0 software and DivX Plus are key initiatives which are expected to help propel the Company forward.

Another program that is key to our future is the DivX Connected Program. We're seeing interest from our partners in adding DivX Connected devices with network connectivity, in particular, Blu-Ray players and digital televisions.

We believe DivX Connected presents an extremely compelling solution for partners developing network connected devices, and we are optimistic about our success over time as consumers begin to overcome adoption issues related to home networking digital media.

In parallel, we are actively engaging with network operators to offer DivX Connected as an integrated solution to deliver content and services directly to a network set top box. This element of our business is in the early stages, but we have received positive feedback from potential partners and are actively working on product and technology solutions focused on this sector.

DivX Connected is not just about devices, however, and we're continuing to make real traction with the core DivX community around our DivX Connected platforms. We've seen increased engagement around DivX Connected among our users. Thanks to the open nature of the DivX Connected program, anyone can create a simple plug-in that allows virtually any Internet service to be enjoyed through the DivX Connected platform.

In fact, we've seen over 80 plug-ins created covering a variety of services, such as Picasa, FaceBook, BlastFM, and Twitter. Earlier this quarter we released an update to the service that enables Flash-based video sites such as Hulu and YouTube, greatly expanding the pool of content available to DivX Connected users.

In closing, the DivX business continues to thrive. We've made significant progress in all our key areas of focus, from expanding our footprint in key device categories to establishing relationships with major premium content providers and retailers, and developing and releasing cutting-edge video technology embraced by a global community of users. Given the strength of our global brand and our profitable business model, I'm confident we are well-positioned to deliver on our vision, even in difficult economic times.

With that, I'll turn the call over to Dan to discuss our financial results in more detail.

Dan Halvorson

Thank you, Kevin. On today's call, I will provide a summary review of the third quarter and address our EPS and revenue guidance for the full year 2008.

To begin, I'd like to repeat some comments I made last quarter about how we approach our business in the current macroeconomic environment. I think these comments are even more relevant today, given the events which have occurred in the financial markets over the past few months.

We continue to focus on adhering to a few key principles. First, maintain our historically high gross margins. Second, manage expenses tightly and invest to generate long-term returns for the business. And third, focus on delivering strong cash from operations, a key measure of our success.

We are pleased to report that in the third quarter, we achieved all of these objectives. Revenue for the third quarter was $24.4 million, an increase of 11% over the third quarter last year. Our GAAP EPS for the quarter was $0.10 per diluted share, and our GAAP profit was $3.3 million. Non-GAAP EPS was $0.16 per diluted share and we generated non-GAAP profit of $5.4 million.

Excluded from the non-GAAP EPS and net income are the following

One, share-based compensation net of taxes of $0.04 per diluted share; two, the scheduled amortization of purchased intangible assets related to MainConcept net of taxes of $0.01 per diluted share; and three, the foreign exchange impact of a Euro-denominated intercompany loan of $0.01 per diluted share net of taxes.

Breaking the quarter down further, technology licensing revenue for this quarter increased 12% over the same quarter last year. Technology and licensing to hardware manufacturing partners was 63% of total revenues for the quarter. Technology licensing for software, which includes the MainConcept revenue, was 15% of total revenues for the quarter.

We had one licensing customer, that is LG, in the quarter, which accounted for approximately 10% of revenue. Media and distribution revenue for the quarter was approximately $5.3 million or 22% of total revenue. This is a 10% increase over the third quarter of last year. Revenue from our Yahoo toolbar agreement accounted for approximately 21% of total Q3 revenue.

The mix across geographies for the quarter was 58% Asia-Pacific, 28% for the Americas, and 14% for EMEA. Remember that this geographic revenue mix represents the location from which our licensees manufacture products, not the location into which the products are shipped. Gross margins remained at a strong 95%.

Now, let me focus my comments on expenses. I will talk about our expenses consistent with the non-GAAP breakout provided in the supplemental earnings table in our press release today, detailing share-based compensation and the other items discussed earlier. Please remember that we closed the MainConcept acquisition in the fourth quarter of 2007. Consequently, our year-over-year comparisons for all of 2008 are impacted by the addition of the MainConcept team.

We continued to optimize the synergies between DivX and MainConcept. As noted on our previous conference calls, we are seeing deferred revenue from MainConcept fluctuate due to the nature of accounting requirements for revenue recognition. Consequently, we continue to expect revenue and deferred revenue to fluctuate from quarter to quarter as we integrate the MainConcept business, which differs from the traditional DivX business.

Total operating expenses in the quarter of $17.9 million included core DivX business expenses of $15 million or approximately 61% of total revenue. $2.4 million of share-based compensation and the scheduled amortization of purchased intangible assets related to MainConcept of around $600,000.

DivX Q3 operating income, excluding share-based compensation and amortization of intangible assets was $8.3 million or 34% of revenue. Including share-based compensation and amortization, we had a GAAP operating income of $5.3 million.

Our interest income for the quarter was approximately $900,000, which compares the interest income of approximately $2 million earned during the third quarter of last year. The decrease in interest income is primarily due to lower interest rate yield on our cash and investment balances and a lower average cash balance for 2008. The decreasing cash is primarily a result of one, cash used to acquire MainConcept in November of 2007; and two, cash used to repurchase shares of our common stock during the first and second quarters of this year.

Additionally, we had a negative foreign exchange impact of $662,000 during the third quarter related to the impact of a Euro-based intercompany loan between MainConcept and DivX. For the third quarter, share-based compensation expense net of taxes was approximately $1.4 million or $0.04 per diluted share.

We ended the quarter with total cash, short and long-term investments of approximately $130 million or over $4 per share. This includes $17.2 million of securities classified as long-term investments.

Cash provided by operating activities was approximately $14.5 million during the third quarter. We generated $6.6 million from operations and key working capital changes, which includes an $8.4 million decrease in our accounts receivable balance, offset by a decrease in our deferred revenues of approximately $800,000. We did not incur any significant capital expenditures during this quarter.

Our blended tax rate for the quarter was approximately 41%, which is in line with our forecasted tax rate for fiscal 2008. Our Q3 non-GAAP tax rate was approximately 43%.

Now, let me provide an update on our auction rate security investments. We have a par value of approximately $19 million in auction rate securities. We believe our auction rate portfolio is of high quality, as 100% carry AAA rating with no history of default.

In addition, 100% of these auction rate securities are collateralized by the Federal Education Lending Program. As a result of the continued lack of liquidity in the auction market, the fluctuations in the interest rate assumptions used to calculate the value of these investments, during the third quarter we reported an additional unrealized loss of approximately $400,000.

The total unrealized loss reported on our consolidated balance sheet for the first three quarters of 2008 was approximately $1.6 million. We believe this decline in fair value is temporary, based partly on our ability and intent to hold these investments until liquidity returns to the market.

We recently received an offer from one of our investment firms to repurchase $14.5 million of our auction rate securities at par by June 30, 2010. This further supports our belief of the temporary nature of these declines.

Headcount was 332 as of September 30, 2008, which includes 80 employees from MainConcept and compares to just over 380 at the beginning of the year.

Next, let me adjust guidance for the balance of the year. We are increasing our projected 2008 non-GAAP EPS to a range of $0.58 to $0.60 per diluted share, up from $0.52 to $0.58 per diluted share as previously reported in August.

Consumer spending continues to face strong headwinds, and we are therefore refining our top line guidance to $95 million to $97 million, which compares to our previous range of $95 million to $100 million.

Technology licensing revenue is anticipated to be in the range of 75% to 85% of total revenue for the full year. Media and other distribution services are expected to be 15% to 25% for fiscal 2008. We are targeting gross margins for the full year of approximately 95%.

We continue to execute and control costs and cash management. Our tax rate guidance for the balance of the year is anticipated to be approximately 41%. GAAP EPS for 2008 is expected to be in the range of $0.29 to $0.31 per diluted share, which is an increase from previously reported guidance of $0.24 to $0.30 per diluted share and includes one, anticipated non-cash share-based compensation expense of approximately $9.5 million or $0.16 per diluted share net of taxes; two, Stage6-related expenses of approximately $3.3 million or $0.06 per diluted share net of taxes, which was incurred in the first quarter; three, impairment of an intangible asset attributable to the write-off of milestones related to the acquisition of Veatros of approximately $1.3 million or $0.03 per diluted share net of taxes; and four, the scheduled amortization of a purchased intangible asset related to the acquisition of MainConcept of approximately $2.2 million or $0.04 per diluted share, net of taxes. For the balance of the year, we do not anticipate any foreign exchange currency impact on the Euro-based intercompany loan between MainConcept and DivX.

Based on these items, let me repeat that we are increasing our non-GAAP EPS to a range of $0.58 to $0.60 per diluted share, up from $0.52 to $0.58 per diluted share, as previously guided.

Weighted average outstanding shares for the year are expected to be approximately 34 million, which includes the impact from the share repurchase program earlier in the year.

With that, we will open the call for questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions) And we'll take our first question today from John Bright with Avondale Partners. Please go ahead.

John Bright – Avondale Partners

Thank you. Good afternoon. Kevin, first question for you. Connect the dots is the question. You noted the Warner Bros announcement that took place. What else do we need to be thinking about as far as connecting the dots in the premium content world to really position DivX to benefit from the video download market?

Kevin Hell

Sure, well, DivX is really solving the problem of connecting any type of device with any type of content. And premium is one type of content. And on the premium side, as we recently announced, Warner, we have Sony onboard as well, we have CinemaNow. And we expect to continue to add more studios to the mix and add retailers that are selling content in the DivX format. In addition, we're also continuing to drive personal content creation through our software with the launch of DivX 7.0 and our H.264 initiative and Internet-based content as well, and also, web-based video through our web player. On the device side, as we talked about, we continue to launch more and more devices beyond the red laser DVD with exciting new introductions for DTV, set top box, mobile, and Blu-Ray. But it all comes back to essentially allowing any device to reach any content or service. That's ultimately what we're driving to do here. That's the connect the dots.

John Bright – Avondale Partners

Okay. Shifting then, the transition from red laser to Blu-Ray, what should we be thinking about as that transition takes place over the next year period of time? Is there a potential for a gap in revenue at DivX because of this transition? Or do you think this is something that could be more seamless?

Kevin Hell

Well, I think it depends on exactly how it plays out. To a big part, it's going to depend on the impact of the economy. We are seeing Blu-Ray players coming down in price. There are some players out there now that are going below $200 with rebates at retail. But with the macroeconomic condition, it's unclear yet exactly what impact that's going to have on the overall adoption of Blu-Ray. I do expect that at some point, we are going to see a replacement cycle that will drive additional growth in this space. The real question is one of timing, which I think is going to be largely dependent upon the economy at this point in time.

John Bright – Avondale Partners

Okay. Dan, a couple of questions for you. One, on the product development side, sequentially, look like the expense was down a bit. Maybe you can give some color on why that was the case?

Dan Halvorson

Yes. Hey, John. There is – I think all in all, you've got a few things going on, and we're just continuing as in the prepared remarks from both Kevin and myself, we're trying to just continue to manage and control cost. We have headcount, well, headcount's down, we're looking to headcount, we have attrition, natural attrition. We're being very mindful of how we fulfill and refill those positions. So I don't think there's anything that jumps out between the sequential quarters except we're just really trying to be mindful of how we do things and what we do. So I think not only product development, but I think a testament to the bottom line profitability, we are managing costs, not only in product development, but SG&A as well.

John Bright – Avondale Partners

And couple more. What expenses, Dan, when you look at the next year or so, do you view as the most variable expenses, where you might be able to control your expenses the best?

Dan Halvorson

Sure. With this Company, as a lot of people know and most of the analysts that have been through the model with me, obviously, headcount is the biggest driver. But that's not the most variable. I think its things where we have to be smart and judicious on things like the January CES program. What do we spend out on marketing? So the sales and marketing, kind of the outside things. Obviously, our headcount and our people are very important to us, so we look at that. But I think the elastic areas that – I'd like to say my audit fees, my D&O insurance, my G&A are elastic, but those aren't. Unfortunately, that's part of the public company costs. But I think its areas around marketing and promotion and what we do in those areas, how smart we are with co-marketing with our partners. That's probably the biggest area. And then there is other areas like you're asking the question on the product development, of how we develop, how we design. We're continuing to look at our certification programs. Do we continue to do that here in San Diego? Do we do it elsewhere? So there is a variety of things we look at. But that's – those are some of the indicative areas, John.

John Bright – Avondale Partners

Okay. Couple, final clean-up one, then. Dan, what, in the technology licensing, what was the percentage of revenues from devices other than DVD players?

Dan Halvorson

It's still, we have said we'll break out the emerging – that goes with the heart of what's the emerging categories. It's still small, but the good news is its growing. We've talked about we'll break it out when we get into the SEC areas, which is usually 10%. But what I had said before is I'll start giving color when, even if it doesn't hit that kind of the SEC 10%. In the emerging areas we're making traction. You're seeing the press releases. You're seeing the other drivers that Kevin alluded to. So it's a small area, but it's early innings on that.

John Bright – Avondale Partners

Last question. What should we think about for an interest rate looking forward, one? And then two, you're building up nice balances of cash. You certainly did this quarter as well. Any discussion on use of cash?

Dan Halvorson

Not really a discussion. I think, John, that's a fair question. We're very pleased with the cash generation this quarter, up to $130 million, over $4 a share. The use of cash is one that I think, in this day and age, right now, with this macroeconomic environment, I think the saying comes to mind is, "Keep your powder dry." And we're going to continue to manage cash. We're going to continue to watch that. Obviously, the investors saw that management thought it was prudent, had the board approved in the first part of the year, a buyback. We did a $20 million buyback. While we stand behind that, who would have had the foresight – 20/20 hindsight to see the stock, which we bought at good prices, even drift further south.

So I get a lot of questions from investors and analysts about, "Would you do another buyback?" And while we look at that, I think, really, it's, I think it's really prudent right now to be mindful of where we're at, keep our powder dry and continue to execute on the plan. The other part of that from the interest rate, it's a low rate, unfortunately. It's in the couple percentage point. I think we're at a point where this year, this quarter, it was $900,000. I think that's a good thing to model, depending on what happens with our cash balances. But it's unfortunately a low number for us, as well as anybody else with cash investments.

John Bright – Avondale Partners

Thank you.

Dan Halvorson

Thanks, John.

Operator

And we'll take our next question from Paul Coster with JP Morgan.

Paul Coster – JP Morgan

Great. Thanks very much. We like this prudent stand. Okay. Going back to premium content for a second, I didn't really understand from the answer what to expect next. Are we going to start seeing this stuff distributed, and what is the revenue generator for DivX?

Kevin Hell

Yes, sure, Paul. We will continue to focus on adding additional studios in addition to Warner and Sony, as well as pursue retailers such as CinemaNow and others so that they can sell content online in the DivX format that can be consumed on the over 100 million devices. So that's really what we're focused on right now is adding additional studios. We just recently added Warner to the mix, which gets us up to close to 50% of all digitally available titles. And that really starts becoming attractive to retailers that can then sell that content to reach the over 100 million devices that are out there in the market today that have our DRM inside. So that's what we're really focused on at this point in time.

In terms of the revenue model associated with that, there is – right now we have a video-on-demand system that we've been operating for several years, and that's a revenue share model. But when we're talking about premium content, we're really moving to a model where there will likely be very little, if any, direct revenue to DivX. But there are several forms of revenue to DivX that we see from this coming. The first would be, obviously, the indirect revenue associated with the benefits we get from our licensing partners. Right now, with these announcements with Warner Bros and with Sony, we're seeing immediate impact on the licensing renewals we have with major OEMs and that's hitting the top line right away.

In addition, as these retailers launched, given the very significant size of our community and the numbers that I mentioned around the number of visitors to our Web site, we expect that we'll be able to drive significant eyeballs to these new sites as they emerge. And as we do that, we expect we'll be able to participate in the customer position revenues that would be associated with that and the marketing opportunities that would be associated with that. So, so, probably not direct transactional revenue, but absolutely marketing revenue associated with driving eyeballs to these sites.

Paul Coster – JP Morgan

When do you think I'll be able to download my first DivX movie through CinemaNow?

Kevin Hell

Well, as soon as we get CinemaNow and other retailers up. And we're actively working on that and we'll keep you posted as soon as we get that.

Paul Coster – JP Morgan

DivX 7.0, will it be backwardly compatible, and how will it be branded?

Kevin Hell

Yes, so the – both on the software and on the hardware side, it will be backwards compatible. So the software will play back all the existing MPEG-4 based DivX and the devices will also play back all the existing MPEG-4 based DivX. The way that it's branded is the software will be branded DivX 7.0, and in that software, if you're using a converter, you'll see various profiles that will allow you to create content suitable for different devices with the DivX Plus logo. So on the devices, their certification logo will be DivX Plus. And DivX Plus will indicate support for H.264, the new format, as well as all the existing MPEG-4 based content as well.

Paul Coster – JP Morgan

If I have a DivX Plus file though I won't be able to play it back on the DivX device?

Kevin Hell

If you have an H.264 file by definition you're not going to be able to play it back on the existing DivX devices, which are all MPEG-4 based.

Paul Coster – JP Morgan

Is the royalty per unit the same for DivX Plus as for prior generations?

Kevin Hell

No. We're looking for a premium, and most of the devices that have been target devices for DivX Plus will be – HDTV will also be DivX Plus HD, most likely. And there will be Blu-Ray devices, set top boxes, and DTVs.

Paul Coster – JP Morgan

Okay, great. When do we expect to see those on products selling through retail?

Kevin Hell

Well, we're releasing our SDK, actually, will it be gold master at the end of this week, and then over the next two weeks, we'll be shipping it out to our partners. They will start to incorporate the technology into the chips and into the devices. And we expect to see devices shipping toward the back half of 2009, revenue coming at the very end of 2009 and then into 2010. So you'll start to see products in the marketplace some time in late 2009.

Paul Coster – JP Morgan

We note that you reduced your R&D spend this quarter. Is there any tradeoff as a result? So what are we forfeiting as a result of doing that?

Kevin Hell

We're not really forfeiting anything specifically. I would really attribute it to just prudent management of the expenses, of the overall development activities.

Paul Coster – JP Morgan

Dan, do you think you can bring down the tax rate in '09?

Dan Halvorson

That's one of these good problems with making money. We continue to look at tax strategies, we continue to look – the short answer is I wouldn't think so. Well just I'll kind of live with the 41-ish percent. We'll continue to look at that, Paul. We look at jurisdictions. Germany now with MainConcept. You know, this small DivX has gotten more complex in that area. So between US, Germany, and other jurisdictions, we'll continue to look at that. That's a fair question, but for right now, I think I'd leave it at where it's at.

Paul Coster – JP Morgan

A last question. Kevin, can you comment at all about your outlook for '09?

Kevin Hell

Not at this point in time. No, we're not ready for that yet. We're still a bit away from that.

Paul Coster – JP Morgan

Okay. Thank you.

Kevin Hell

Sure.

Operator

(Operator instructions) And we do have a question from Jim Goss from Barrington Research. Please go ahead. Mr. Goss, your line is open.

Jim Goss – Barrington Research

Okay. Sorry. I was wondering with the Netflix, TiVo announcement, if that looks like something that can pave the way to – for DivX Connected or it provides somewhat of another barrier to entry, another competitor that might make it further up?

Kevin Hell

Sure. Hi, Jim. So we see Netflix as absolutely a potential partner over time, and we believe that our installed base of devices and our relationships will be attractive as they look to get their service out more broadly. This specific device with TiVo and some of the other devices that are out there, but Netflix, I think represent interesting; I call them experiments into delivering streaming digital media to devices. And I think – but ultimately, they're really focused on, in most cases, very narrow. These cases are around a specific service to a specific device. And as I was talking about at the outset, we're really trying to solve the problem of really any content or service to any device. Very open, scalable platform that can connect all different types of services, whether they be YouTube or Hulu or premium services like Netflix or Amazon, to any type of device. That's really what we're building, we're building the infrastructure for that. We believe that as that starts to develop, services like Netflix and others will start to see the appeal of that and come onboard to be able to reach all the different devices we have out there in the marketplace.

Jim Goss – Barrington Research

As Blu-Ray has developed, BDLive is serving an integral part of that development. And I wonder if that also smoothes the way to get information from computers and elsewhere to your television (inaudible).

Kevin Hell

Yes, absolutely. Yes, absolutely. It does. It's something that we're very excited about in that the adoption of the Blu-Ray Live will mean that BD players will start to come standard with connectivity. Also, DTV start getting connectivity in the top end of the product ranges, and the top third of some of the product ranges. And that means that these devices will be able to fairly easily support DivX Connected, because DivX Connected ultimately only requires connectivity and the ability to play back a decoded DivX video frame. And if you can do both those things, then you can support our DivX Connected program. So we find that to be a very positive development for us overall for DivX Connected platform.

Jim Goss – Barrington Research

How does that affect your economics then, do you then not have to sell a certain device, but you can raise your license fees or perhaps – ?

Kevin Hell

Yes, it allows to essentially drive for higher licensing fees. We would get, obviously, a fee for playback, and then we would get the additional fee associated with DivX Connected experience on top of that.

Jim Goss – Barrington Research

And last thing I'd ask is as DivX 7.0 comes onboard, how do you position that versus your original codec in terms of the various applications it can have?

Kevin Hell

Well, it's new and improved. It's adding support for H.264, which is next generation codec. It allows for increased compression over our historical MPEG-4 based codec. And so it will be positioned squarely in the middle of the Web site. We're actually redesigning our Web site to feature DivX 7.0. We're very excited about the branding of DivX 7.0 and how it's going to be featured on the Web site. And we expect to see significant increase in traffic and community engagement once we release that.

Jim Goss – Barrington Research

Alright. Thanks very much.

Kevin Hell

Sure.

Operator

And we'll now take a question from Justin Cable with Global Hunter Securities. Please go ahead.

Justin Cable – Global Hunter Securities

Hi. Thank you. Question on your renewal, as a result of getting Warner Bros, you mentioned that the renewals have improved. Can you talk at all about what you're seeing in terms of pricing trends in your royalty negotiations, both with the renewals and with (inaudible)?

Kevin Hell

Sure. So we've seen, on renewals, we've seen very good and positive progress with regards to all of our renewals with our tier one major OEMs. We, to date, have still not lost a major OEM and make great progress there. Many of these renewals are coming in, not only in two years, but now in some cases in three years, around just the DVD segment alone. So that's real good for our business overall, and it gives us a certain minimum commitment and it gives us a certain amount of stability to our future.

In terms of the impact, yes, we are seeing a positive impact on our renewals in terms of getting them done in either higher volume commitments or some other form. Our ASPs have taken a tick up for this quarter, although our ASPs do bounce around from quarter to quarter. Overall, I would say our ASPs are generally solid and consistent over time, over the last three years or so. Now, we do expect that with the introduction of HD and DivX Plus HD, which is our H.264 solution, we'll be able to see a premium and start to see, in some cases, our ASP stick out for new products.

Justin Cable – Global Hunter Securities

What's the price differential between HD and as well as the royalties for other devices outside of red laser?

Kevin Hell

It's hard to say at this point in time. We will on a rack rate basis look for a 30% or 50% type premium for HD and DivX Plus. But realistically, we might end up with something more like 10% to 20% premium. We'll see where it plays out.

Justin Cable – Global Hunter Securities

Okay. On the balance sheet, DSOs came down. You had some good collections. Can you give some color on that?

Dan Halvorson

No, I think you've got it, Justin. It's really good collections, solid collection. We've always had solid, tier one customers, and it's just the timing. The team did some solid efforts, and just worked the clients, customers, and we did quite well there. So it was, I guess, arguably, the last couple of quarters were probably a little higher than I would like to have seen them as well. So if you go back from the December quarter, March quarter, and June quarter, I'd say that ARs had drifted upwards a little bit, and they're right, they're actually better than I expected them to be. So you see the bolt from operations as well as the working capital changes, primarily, is noted in my prepared script, AR, the color is really just timing. And some of these customers aren't, as we mentioned, LG's 10% of it. We have several that are in the 8% range, and if one of those customers drifts over quarter-end, then you have an impact there. But the good news is we all work as a team, work with our customers, got the cash in, and you see the results of that about $130 million or $4 per share in cash.

Justin Cable – Global Hunter Securities

If I take a look at the technology, obviously, the next focus is the H.264 for you guys. Have you considered including any other features outside of that going forward?

Kevin Hell

Well, we're going to continue to monitor other formats to see if other possible formats start to emerge and add that to our mix. To-date, if you look on the web which is in Internet content downloads, majority of it is in either an MPEG-4 based format or now you're getting emerging H.264 content. About 10% of the content online now is actually HD format, and a big majority of that is actually in .mkv file containers, which includes H.264 inside. And so that's a growing trend that we're well positioned to capitalize on. Beyond that, we're not seeing a lot of other formats. There is a possibility in the future we will see Flash-based video files emerge. And even if that was to be the case, we could include that in our overall certification program. But for disc connected playback, we download a file to your PC and you burn it on a disk and walk it over to a device. To-date, really the only real formats we're seeing out there are MPEG-4 based formats like DivX Connects did. And increasingly, H.264, which we're well positioned for.

Justin Cable – Global Hunter Securities

And my last question. You mentioned the penetration rate for red laser in your prepared comments. Do you have the penetration rates for the other product categories, DTV, set top box, mobile, Blu-Ray?

Kevin Hell

Well, we haven't – no, we haven't announced that yet. We're obviously in early stages. So what we have talked about is all the OEMs that we've signed up and the number of SKUs that are starting to come out. I can talk about, for instance, in the Blu-Ray category, we've made really great progress in a very short period of time. We certified 42 Blu-Ray devices here in Q3, which was doubling the number of certified devices in one quarter. We're up to 60 certified Blu-Ray devices to-date when you exclude the PS3. We've got LG, Samsung, JVC, Pioneer, Onkyo, Panasonic, and then Marantz and Phillips now, with US product from Phillips, Panasonic, Denon, and Marantz. So, very good progress there.

Our penetration in Europe, we're actually already up to 26% for the Blu-Ray category in Europe, and that's a tremendous increase from where we were earlier in the year. If you look at all of our partners that we already have signed up, they represent a 45% share of the total market, and we expect to add more to that very, very quickly. In the other categories on the DTV side, we just signed up Samsung. Samsung is the leader worldwide in market share for the digital televisions. That was a tremendous add. We also have, as you know, LG onboard, and they have now 38 certified models. We have roughly 116 total DTV SKUs, and we expect that to be a significant player in 2009. But we haven't yet got to the point of computing the penetration rate there. As we start to grow there, and as Dan mentioned, as we get certain thresholds, we'll start to report more regularly the penetration level on that.

On the gaming side, we have the Sony PlayStation 3 dot devices fully certified at this point in time. That's 75% of the Blu-Ray market overall and represents one of the big three of the gaming console market, so we have that level of penetration on the gaming side based on PS3s market share overall. Now, on the mobile side, we released 15, we have 15 products on the market today that are DivX certified from LG and Samsung, which are two of the top five market share leaders for mobile phone. We expect to add more over time. We are seeing some other operator – other mobile handsets as well.

Justin Cable – Global Hunter Securities

Great. Thank you.

Kevin Hell

Sure.

Operator

And we now have a follow-up question from Paul Coster with JPMorgan. Please go ahead.

Paul Coster – JP Morgan

Yes, thank you. So the Web site activities increased year-on-year, but I do note, according to electric.com, anyway, that the Web site activity slowly slid a little bit since August. Why is that and how does 7.0 change things, do you think?

Kevin Hell

Well, I don't know the exact numbers you're looking at, Paul. I do know that there is some amounts of seasonality, and things go up and down, and that's why we like to report numbers over a reasonable of period of time to take out the inevitable spikes and valleys that occur from time to time. I can tell you that in Q3 versus Q2, our unique visitors at DivX.com were up 11%, and page views were up 12%.

So I think if you look at the numbers quarterly, that's a pretty good metric on that. And I do expect, when we do launch DivX 7.0, we'll see significant increases as well on top of that. It's interesting to note, as I mentioned in the prepared remarks, that our uniques to DivX.com, prior to Stage6 and now after Stage6 are up 66%. So that's a dramatic increase. And so I think overall I'm very bullish on the overall size and scope of the DivX community and its growth overall.

Paul Coster – JP Morgan

Okay. And last question from me. You know that there has been some trade-downs in the world of consumer electronics. As people de-feature, what's this going to do to your royalty rate on the red laser platform in particular?

Kevin Hell

Well, as I mentioned, we're continuing to see good firm ASPs in the red laser category. I do agree that in the lower end models, you are starting to see some de-featuring, and DivX can be impacted by that in general. I think a lot of their – if you look at our partners overall, what they're focusing now on is really their development resources, and their technology integration efforts are really focusing on the emerging segments. Lot of their attention is just taking off of DVD, moving to Blu-Ray, moving to DTV and other categories like that. And we're really moving with them, because these are products that really are looking for differentiation as they come to market, and that's where DivX really helps them play over time.

Paul Coster – JP Morgan

Thank you.

Kevin Hell

Sure.

Operator

And there are no other questions. So I'd like to turn the call back to Kevin Hell for any additional or closing remarks.

Kevin Hell

Well, I want to thank everyone for joining us today, and we look forward to talking with you next quarter. Thanks very much.

Operator

And thank you very much. That does conclude our conference for today.

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Source: DivX, Inc. Q3 2008 Earnings Call Transcript
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